Brehm CH 2

Question 1

What is deterministic project analysis?

Answer 1

Using a single deterministic forecast for project
cash flows, an objective function such as present value or internal rate of return is produced. Sensitivities to critical variables may be shown. Uncertainty (along with other intangibles) is handled judgmentally (i.e., intuitively) by decision makers.

Question 2

What is risk analysis?

Answer 2

Forecasts of distributions of critical variables are fed into a
Monte Carlo simulation engine to produce a distribution of present value of cash flows. Risk judgment is still applied intuitively.

Question 3

What is certainty equivalent?

Answer 3

Certainty Equivalent - Certainty equivalent is an extension of risk analysis that quantifies the intuitive risk judgment by means of a corporate risk preference or utility function. The utility function does not replace judgment but simply formalizes the judgment so it can be consistently applied.A

Question 4

What comprises market value?

Answer 4

book value (recorded value of held assets) plus franchise value (present value of future earnings growth)

Question 5

What is a corporate risk tolerance?

Answer 5

A combination of factors; organization size, financial resources, ability and willingness to tolerate volatility

Question 6

In order to select an efficient frontier portfolio, what 3 questions must a firm answer?

Answer 6

How much risk (sd) are we willing to tolerate?
how much reward are we willing to give up for a given reduction in risk?
are the risk-reward tradeoffs available along the efficient frontier acceptable to us?

Question 7

Economic value added formula

Answer 7

NPV Return - Cost of Capital

Question 8

What are the advantages of economic capital?

Answer 8

It provides a unifying measure for all risks across an organization.
It is more meaningful to management than risk-based capital or capital adequacy ratios.
It forces the firm to quantify the risks it faces and combine them into a probability distribution.
It provides a framework for setting acceptable risk levels for the organization as a whole and for individual business units.

Question 9

Moment-based risk measures

Answer 9

start with probabilistic expectations of random variables
disadvantage of var/sd => treats favorable and adverse outcomes the same
semi-sd is better
some evidence quadratic risk measures arent enough => skewness better
exponential moments can encapsulate all moments
E[Ye^cY / EY] (usually only exists with an upper bound)

Question 10

Tail-based measures

Answer 10

emphasize large losses only
VaR
TVaR
XTVaR (TVaR - mu)
EPD = (1-p)*(TVaR - VaR)
Value of default option

Question 11

Probability transform risk measures

Answer 11

shift outcomes towards unfavorable
compute with distorted probabilities
CAPM and BS can be expressed as transformed means
wang transform mean can closely approximate market prices
add “weighted” to a tail risk measure if computed with distorted probabilities

Question 12

What purpose does allocating risk measures serve?

Answer 12

shows the contribution of each business unit to the company risk
can be used for setting capacity controls like premiums and limits by line and be used as a basis for calculating risk-adjusted profitability

Question 13

Co-measures

Answer 13

p(Y) = E[h(Y) L(Y) | g(Y)]
h = additive function
g = condition about Y
L = any function where conditional EV exists

Question 14

When is there a marginal risk allocatiom method?

Answer 14

If the risk is scalable (positive homogeneous)
marginal attribution = proportional change in company risk measure due to a small change in the units volume
it is a comeasure => all marginal attributions sum up to the company risk measure
common risk measure expressed in dollars are scalable

Question 15

Leverage ratios

Answer 15

used for many years to evaluate capital adequacy
NWP / Surplus < 3
Net Reserves / Surplus < 3
IRIS Ratios (4+ outside range = regulatory scrutiny)

Question 16

What are some types of risk included in risk-based capital models?

Answer 16

Invested asset, credit, premium, and reserve
multiply factor by accounting value
most include accumulation risk

Question 17

What can explain differences in asset factor values between different risk-based capital models?

Answer 17

(1) Model use. Evaluating long-term viability or one year solvency?
(2) Presence of covariance adjustment. These reflect independence of various risk components (greater reduction when risk charges are relatively similar in amount) often higher factors are reduced by a covariance adjustment

Question 18

What’s the largest component of credit risk in risk based capital models?

Answer 18

Reinsurance recoverables
several models have risk factors that vary with the credit quality of the reinsurers
AM Best increases if company relies heavily on reinsurance

Question 19

What type of risk shows the largest differences amongst rbc models?

Answer 19

accumulation risk
most models use return periods of 100 to 250 years
natural perils such as wind, hail, and earthquake

Question 20

Scenario testing

Answer 20

solvency monitoring through the use of static or stochastic scenario testing
insurers demonstrate the impact on capital of a list of scenarios
usually involves preparation of a one to five year financial projection model

The thresholds for evaluating regulatory capital adequacy in use
today are:
Great Britain - no more than 2.5 percent probability of ruin over 5 years, 1.5 percent probability of ruin over 3 years or 0.5 percent probability of ruin in 1 year.
~ Australia - no more than 0.5 percent probability of ruin in 1 year.

Question 21

What is asset-liability matching?

Answer 21

Matching refers to establishing and maintaining an
investment portfolio - typically fixed income - that has the same duration characteristics or even the same cash flow patterns as the liability portfolio it supports.

Question 22

What is asset-liability management?

Answer 22

comprehensive analysis and management of the asset portfolio in light of current liabilities and future cash flows of a going-concern company, incorporating existing asset and liability portfolios as well as future premium flows

Asset-liability management beyond duration
matching considers additional risk factors beyond interest rate changes, such as inflation risk, credit risk and market risk.
seeks to exploit hedges

Question 23

What is a principal driver in insurers investment decisions?

Answer 23

over the UW cycle insurers go from tax-exempt and taxable fixed income securities (UW losses absorb taxable investment income)

Question 24

What are the 9 steps of modeling for ALM?

Answer 24

(1) Begin with models of asset classes, existing liabilities, and current operations
(2) Define risk metrics (volatility or ending surplus)
(3) Management decides, what is return?
(4) Determine time horizon of analysis (one year or longer?
(5) consider constraints such as asset class limits by regulation
(6) run for many investment and uw strats, and reinsurance options
(7) efficient frontier constructured over scenarios
(8) consider drastic effect of reinsurance on liabilities even if theyre illiquid
(9) review simulations to identify situations where preferred portfolios did poorly (possibly can use hedging to improve)

Question 25

2 examples of “future” research on ALM

Answer 25

correlations between LOBs whether in current business or reserves between assets and liabilities are poorly understood

models of unpaid losses havent been developed as explantory models (dont predict losses linking them to economic indices)

Question 26

What are the three main benefits of reinsurance?

Answer 26

(1) Provides stability. protection of surplus against adverse fluctuations
(2) Frees up capital. incremental stability gained frees up risk capital that would be required.
(3) adds value to the firm.

Question 27

2 classes of required capital models

Answer 27

1. “Theoretical models” - those that derive required capital and changes in it based on the calculated risk metrics from an enterprise risk model
2. “Practical models” - those that derive required capital for the company by concession to the reality of various rating agency formulas (e.g., BCAR, S&P CAR), regulatory requirements (e.g., RBC, !CAR) or actual capital.

Question 28

What purposes do the “as-if” reserves serve?

Answer 28

for an AY of new business, as-if reserves are reserves that would exist if business had been written in a steady-state in years prior
(1) can measure the impact of accumulated risk caused by correlated risk factors
(2) reinsurance being analyzed can be applied to the AY and the as-if reserves, providing a more valid measure of the impact of reinsurance

Question 29

What are some features of time-related projection risk?

Answer 29

severity trend applied to the date of loss payment
severity trend risk is modeled according to the AR-1 time series model

Question 30

What have recent studies discovered about relationships between capital, earnings, growth and value?

Answer 30

Insureds demand price discounts of 10 to 20 times the expected cost of the chance of an insurer default
1 percent decrease in capital gives a 1 percent loss· in pricing, and a 1 percent increase in the standard deviation in earnings leads to a 0.33 percent decrease in pricing
A ratings upgrade is worth 3 percent in business growth, and a ratings downgrade can produce a 5. to 20 percent drop in business